1. Chapter 2 The Basics of Supply and Demand

2. Chapter 2: The Basics of Supply and DemandSlide 2 Introduction Applications of Supply and Demand Analysis Understanding and predicting how world economic conditions affect market price and production Analyzing the impact of government price controls, minimum wages, price supports, and production incentives

3. Chapter 2: The Basics of Supply and DemandSlide 3 Supply and Demand The Supply Curve The supply curve shows how much of a good producers are willing to sell at a given price, holding constant other factors that might affect quantity supplied

4. Chapter 2: The Basics of Supply and DemandSlide 4 Supply and Demand The Supply Curve This price-quantity relationship can be shown by the equation:

5. Chapter 2: The Basics of Supply and DemandSlide 5 Horizontal axis measures quantity (Q) supplied in number of units per time period Vertical axis measures price (P) received per unit in dollars Supply and Demand The Supply Curve Graphically The Supply Curve Graphically Quantity Price ($ per unit)

6. Chapter 2: The Basics of Supply and DemandSlide 6 Supply and Demand S The supply curve slopes upward demonstrating that at higher prices firms will increase output The Supply Curve Graphically The Supply Curve Graphically Quantity Price ($ per unit) P1P1 Q1Q1 P2P2 Q2Q2

7. Chapter 2: The Basics of Supply and DemandSlide 7 Supply and Demand Non-price Determining Variables of Supply Costs of Production  Labor  Capital  Raw Materials

8. Chapter 2: The Basics of Supply and DemandSlide 8 Supply and Demand The cost of raw materials falls At P 1, produce Q 2 At P 2, produce Q 1 Supply curve shifts right to S ’ More produced at any price on S ’ than on S P S Change in Supply Q P1P1 P2P2 Q1Q1 Q0Q0 S’ Q2Q2

9. Chapter 2: The Basics of Supply and DemandSlide 9 Supply and Demand The Demand Curve The demand curve shows how much of a good consumers are willing to buy as the price per unit changes holding non-price factors constant. This price-quantity relationship can be shown by the equation:

10. Chapter 2: The Basics of Supply and DemandSlide 10 Supply and Demand Quantity Horizontal axis measures quantity (Q) demanded in number of units per time period Vertical axis measures price (P) paid per unit in dollars Price ($ per unit)

11. Chapter 2: The Basics of Supply and DemandSlide 11 Supply and Demand D The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper and the consumer’s real income increases. Quantity Price ($ per unit)

12. Chapter 2: The Basics of Supply and DemandSlide 12 Supply and Demand Non-price Determining Variables of Demand Income Consumer Tastes Price of Related Goods  Substitutes  Complements

13. Chapter 2: The Basics of Supply and DemandSlide 13 D P Q Q1Q1 P2P2 Q0Q0 P1P1 D’ Q2Q2 Change in Demand Supply and Demand Income Increases At P 1, purchase Q 2 At P 2, purchase Q 1 Demand Curve shifts right More purchased at any price on D’ than on D

14. Chapter 2: The Basics of Supply and DemandSlide 14 The Market Mechanism Quantity D S The curves intersect at equilibrium, or market- clearing, price. At P 0 the quantity supplied is equal to the quantity demanded at Q 0. P0P0 Q0Q0 Price ($ per unit)

15. Chapter 2: The Basics of Supply and DemandSlide 15 The Market Mechanism Quantity D S P0P0 Q0Q0 If price is above equilibrium: 1) Price is above the market clearing price 2) Q s > Q d 3) Price falls to the market-clearing price P1P1 Surplus Price ($ per unit)

16. Chapter 2: The Basics of Supply and DemandSlide 16 The Market Mechanism D S Q1Q1 Assume the price is P 1, then: 1) Q s : Q 2 > Q d : Q 1 2) Excess supply is Q 2 – Q 1. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P 2 Q 3 P1P1 Surplus Q2Q2 Quantity Price ($ per unit) P2P2 Q3Q3

17. Chapter 2: The Basics of Supply and DemandSlide 17 The Market Mechanism D S Q1Q1 Q2Q2 P2P2 Shortage Quantity Price ($ per unit) Assume the price is P 2, then: 1) Q d : Q 2 > Q s : Q 1 2) Shortage is Q 2 – Q 1. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P 3, Q 3 Q3Q3 P3P3

18. Chapter 2: The Basics of Supply and DemandSlide 18 The Market Mechanism Market Mechanism Summary 1)Supply and demand interact to determine the market-clearing price. 2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. 3)Markets must be competitive for the mechanism to be efficient.

19. Chapter 2: The Basics of Supply and DemandSlide 19 The Price of a College Education The real price of a college education rose 68 percent from 1970 to 1995. Supply decreased due to higher costs of equipping and maintaining modern classrooms, laboratories and libraries, and higher faculty salaries. Demand increased due to a larger percentage of a growing number of high school graduates attending college.

20. Chapter 2: The Basics of Supply and DemandSlide 20 Market for a College Education Q ( millions of students enrolled)) P ( annual cost in 1970 dollars) D 1970 S 1970 S 1995 D 1995 $4,573 12.3 Prices rose until a new equilibrium was reached at $4,573 and a quantity of 12.3 million students $2,530 7.4

21. Chapter 2: The Basics of Supply and DemandSlide 21 Consumption & Price of Copper 1880-1998

22. Chapter 2: The Basics of Supply and DemandSlide 22 S 1998 D 1998 D 1900 S 1900 S 1950 D 1950 Long-Run Path of Price and Consumption Changes In Market Equilibrium Quantity Price

23. Chapter 2: The Basics of Supply and DemandSlide 23 Observation To accurately predict the future price of a product or service, it is necessary to consider the potential change in supply and demand. 1970 predictions for oil and other minerals proved incorrect because they only considered the demand side of the market. Changes In Market Equilibrium

24. Chapter 2: The Basics of Supply and DemandSlide 24 Elasticities of Supply and Demand Generally, elasticity is a measure of the sensitivity of one variable to another. It tells us the percentage change in one variable in response to a one percent change in another variable.

25. Chapter 2: The Basics of Supply and DemandSlide 25 Elasticities of Supply and Demand Measures the sensitivity of quantity demanded to price changes. It measures the percentage change in the quantity demanded for a good or service that results from a one percent change in the price. Price Elasticity of Demand

26. Chapter 2: The Basics of Supply and DemandSlide 26 Elasticities of Supply and Demand The price elasticity of demand is:

27. Chapter 2: The Basics of Supply and DemandSlide 27 Elasticities of Supply and Demand The percentage change in a variable is the absolute change in the variable divided by the original level of the variable. Price Elasticity of Demand

28. Chapter 2: The Basics of Supply and DemandSlide 28 Elasticities of Supply and Demand So the price elasticity of demand is also: Price Elasticity of Demand

29. Chapter 2: The Basics of Supply and DemandSlide 29 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 1)Because of the inverse relationship between P and Q; E P is negative. 2)If |E P | > 1, the percent change in quantity is greater than the percent change in price. We say the demand is price elastic.

30. Chapter 2: The Basics of Supply and DemandSlide 30 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 3)If |E P | < 1, the percent change in quantity is less than the percent change inprice. We say the demand is price inelastic.

31. Chapter 2: The Basics of Supply and DemandSlide 31 Elasticities of Supply and Demand The primary determinant of price elasticity of demand is the availability of substitutes. Many substitutes: demand is price elastic Few substitutes: demand is price inelastic Price Elasticity of Demand

32. Chapter 2: The Basics of Supply and DemandSlide 32 Price Elasticities of Demand Q P rice Q = 8 - 2P E p = -1 E p = 0 The lower portion of a downward sloping demand curve is less elastic than the upper portion. 4 8 2 4 Linear Demand Curve Q = a - bP Q = 8 - 2P

33. Chapter 2: The Basics of Supply and DemandSlide 33 Price Elasticities of Demand D P*P* Quantity Price Infinitely Elastic Demand

34. Chapter 2: The Basics of Supply and DemandSlide 34 Price Elasticities of Demand Q*Q* Quantity Price Completely Inelastic Demand

35. Chapter 2: The Basics of Supply and DemandSlide 35 Elasticities of Supply and Demand Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income. Other Demand Elasticities

36. Chapter 2: The Basics of Supply and DemandSlide 36 Elasticities of Supply and Demand The income elasticity of demand is: Other Demand Elasticities

37. Chapter 2: The Basics of Supply and DemandSlide 37 Elasticities of Supply and Demand Cross price elasticity of demand measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good. For example consider the substitute goods, butter and margarine. Other Demand Elasticities

38. Chapter 2: The Basics of Supply and DemandSlide 38 Elasticities of Supply and Demand The cross price elasticity of demand is: The cross price elasticity for substitutes is positive, while that for complements is negative.

39. Chapter 2: The Basics of Supply and DemandSlide 39 Elasticities of Supply and Demand Price elasticity of supply measures the percentage change in quantity supplied resulting from a 1 percent change in price. The elasticity is usually positive because price and quantity supplied are positively related. Higher price gives producers an incentive to increase output Elasticities of Supply

40. Chapter 2: The Basics of Supply and DemandSlide 40 Elasticities of Supply and Demand We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials. Elasticities of Supply

41. Chapter 2: The Basics of Supply and DemandSlide 41 Short-Run Versus Long-Run Elasticities Price elasticity of demand varies with the amount of time consumers have to respond to a price. Demand

42. Chapter 2: The Basics of Supply and DemandSlide 42 Most goods and services: Short-run elasticity is less than long-run elasticity. (e.g. gasoline, Drs.) Other Goods (durables): Short-run elasticity is greater than long-run elasticity (e.g. automobiles) Short-Run Versus Long-Run Elasticities Demand

43. Chapter 2: The Basics of Supply and DemandSlide 43 Gasoline: Short-Run and Long-Run Demand Curves D SR D LR People tend to drive smaller and more fuel efficient cars in the long-run Gasoline Quantity Price

44. Chapter 2: The Basics of Supply and DemandSlide 44 D SR D LR People may put off immediate consumption, but eventually older cars must be replaced. Automobiles Automobiles: Short-Run and Long-Run Demand Curves Quantity Price

45. Chapter 2: The Basics of Supply and DemandSlide 45 Income elasticity also varies with the amount of time consumers have to respond to an income change. Short-Run Versus Long-Run Elasticities Income Elasticities

46. Chapter 2: The Basics of Supply and DemandSlide 46 Most goods and services: Income elasticity is greater in the long-run than in the short run.  Higher incomes may be converted into bigger cars so the income elasticity of demand for gasoline increases with time. Short-Run Versus Long-Run Elasticities Income Elasticities

47. Chapter 2: The Basics of Supply and DemandSlide 47 Other Goods (durables): Income elasticity is less in the long-run than in the short-run.  Originally, consumers will want to hold more cars.  Later, purchases will only to be to replace old cars. Short-Run Versus Long-Run Elasticities Income Elasticities

48. Chapter 2: The Basics of Supply and DemandSlide 48 Gasoline The long-run price and income elasticities are larger than the short-run elasticities. Automobiles The long-run price and income elasticities are smaller than the short-run elasticities. Short-Run Versus Long-Run Elasticities The Demand for Gasoline and Automobiles The Demand for Gasoline and Automobiles

49. Chapter 2: The Basics of Supply and DemandSlide 49 Price-0.11-0.22-0.32-0.49-0.82-1.17 Income0.070.130.200.320.540.78 Years Following Price or Income Change Elasticity 123456 The Demand for Gasoline Short-Run Versus Long-Run Elasticities

50. Chapter 2: The Basics of Supply and DemandSlide 50 Price-1.20-0.93-0.75-0.55-0.42-0.40 Income3.002.331.881.381.021.00 Years Following Price or Income Change Elasticity 123456 The Demand for Automobiles Short-Run Versus Long-Run Elasticities

51. Chapter 2: The Basics of Supply and DemandSlide 51 Data Explains: 1) Why the price of oil did not continue to rise above $30/barrel even though it rose very rapidly in the early 1970s. 2)Why automobile sales are so sensitive to the business cycle. Short-Run Versus Long-Run Elasticities The Demand for Gasoline and Automobiles The Demand for Gasoline and Automobiles

52. Chapter 2: The Basics of Supply and DemandSlide 52 Most goods and services: Long-run price elasticity of supply is greater than short-run price elasticity of supply. Other Goods (durables, recyclables): Long-run price elasticity of supply is less than short-run price elasticity of supply Short-Run Versus Long-Run Elasticities Supply

53. Chapter 2: The Basics of Supply and DemandSlide 53 S SR Primary Copper: Short-Run and Long-Run Supply Curves Primary Copper: Short-Run and Long-Run Supply Curves Quantity Price Short-Run Versus Long-Run Elasticities S LR Due to limited capacity, firms are limited by output constraints in the short-run. In the long-run, they can expand.

54. Chapter 2: The Basics of Supply and DemandSlide 54 S SR Secondary Copper: Short-Run and Long-Run Supply Curves Secondary Copper: Short-Run and Long-Run Supply Curves Quantity Price Short-Run Versus Long-Run Elasticities S LR Price increases provide an incentive to convert scrap copper into new supply. In the long-run, this stock of scrap copper begins to fall.

55. Chapter 2: The Basics of Supply and DemandSlide 55 Elasticity explains why coffee prices are very volatile. Due to the differences in supply elasticity in the long-run and short run. Short-Run Versus Long-Run Elasticities Weather in Brazil and the price of Coffee in New York Weather in Brazil and the price of Coffee in New York

56. Chapter 2: The Basics of Supply and DemandSlide 56 Price of Brazilian Coffee

57. Chapter 2: The Basics of Supply and DemandSlide 57 D S P0P0 Q0Q0 Quantity Price P1P1 Short-Run 1) Supply is completely inelastic 2) Demand is relatively inelastic 3) Very large change in price A freeze or drought decreases the supply of coffee S’ Q1Q1 Short-Run Versus Long-Run Elasticities Coffee

58. Chapter 2: The Basics of Supply and DemandSlide 58 S’ D S P0P0 Q0Q0 P2P2 Q2Q2 Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P 2. 3) Quantity falls to Q 2 Short-Run Versus Long-Run Elasticities Quantity Price Coffee

59. Chapter 2: The Basics of Supply and DemandSlide 59 D S P0P0 Q0Q0 Long-Run 1) Supply is extremely elastic. 2) Price falls back to P 0. 3) Quantity increase to Q 0. Short-Run Versus Long-Run Elasticities Coffee Quantity Price

60. Chapter 2: The Basics of Supply and DemandSlide 60 Effects of Government Intervention -- Price Controls If the government decides that the equilibrium price is too high, they may establish a maximum allowable ceiling price.

61. Chapter 2: The Basics of Supply and DemandSlide 61 D Effects of Price Controls Quantity P rice P0P0 Q0Q0 S P max Excess demand If price is regulated to be no higher than P max, quantity supplied falls to Q 1 and quantity demanded increases to Q 2. A shortage results. Q1Q1 Q2Q2

62. Chapter 2: The Basics of Supply and DemandSlide 62 Summary Supply-demand analysis is a basic tool of microeconomics. The market mechanism is the tendency for supply and demand to equilibrate, so that there is neither excess demand nor excess supply

63. Chapter 2: The Basics of Supply and DemandSlide 63 Summary Elasticities describe the responsiveness of supply and demand to changes in price, income, and other variables. Elasticities pertain to a time frame. If we can estimate the supply and demand curves for a particular market, we can calculate the market clearing price.

64. Chapter 2: The Basics of Supply and DemandSlide 64 Summary Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities.